VC Perspectives from a Former Entrepreneur – Jeff Bussgang

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Monthly Archives: January 2009

I recently read Malcolm Gladwell’s new book, Outliers, with great interest and delight. Gladwell is a fantastic author: always thought-provoking on human behavior and a quick, entertaining read. But I confess this book did not resonate with me or strike me as relevant for the VC-entrepreneur dance in the same way his previous book, Blink, did (see: VCs Blink). It was intellectually interesting, but not professionally illimunating.

Instead, I have been even more taken by another book, which also analyzes human behavior in a thought-provoking way called Sway. Written by Ori and Rom Brafman, Sway was recommended to me by my friend and co-investor Howard Morgan at First Round Capital. It is a fascinating analysis of why human beings naturally fall into irrational behavior. The book has very relevant implications for venture capitalists and entrepreneurs, particularly in today’s environment, as VCs are likely to allow irrational behavior to seep into their portfolio management decisions in the coming years.

Sway points to three central psychological tendencies that cause human beings to behave irrationally, despite the preponderance of facts pointing in another direction. The first is loss aversion, defined as our tendency to go to great lengths to avoid possible loss – even when it means taking outsized risks relative to the actual loss impact. The second is value attribution, where we imbue a person with certain qualities based on our initial impressions (or desired impressions!). And the third is the diagnosis bias, where we allow our initial assessment of a person or situation cloud any further judgment and, in effect, cause us to filter out any contradictory data.

As I look back on the good and bad investment decisions that we have made as a partnership, I see each of these three tendencies factoring into our discussions. It is not uncommon for a polished, confident entrepreneur to benefit from value attribution, when in fact a deeper analysis of their skills and previous experiences as a result of exhaustive reference checking will reveal a very different prognosis. We have tried to be more cognizant of identifying these tendencies in the partnership as we contemplate our future investment decisions with our (relatively) new fund.

As I look forward to managing the portfolio during the challenging times that we all face, I can see where loss aversion, in particular, holds sway in a VC partnership. Human beings prefer to avoid a loss, even if that loss is more costly than the price of continuing forward. One of the dangers in the coming years for the VC business is whether VCs are going to continue supporting companies in order to avoid admitting defeat and taking losses. In many partnerships, the culture may naturally encourage covering things up. Many VC partners are eager to brag about their portfolio successes, but slow to admit when they have made mistakes or when they are in the midst of dealing with a poorly performing portfolio company. Further, partnerships as a whole are going to be loathe to admit problems and failures with their investors, the Limited Partners. Without any malice, portfolio “cover ups” will be common throughout 2009 and 2010.

Loss aversion will thus cause VCs to throw good money after bad in 2009 and 2010. Loss aversion will also cause VCs to report overly optimistic quarterly valuations. I would estimate that many portfolios have valuations that are overstated by 20-30%. And, as I have discussed before (see: "Why 'Flat is the New Up' and VC Funds Are Under-Reserved"), it is also the reason why I think many VC firms are grossly under-reserved. These factors will be exacerbated by most portfolio companies failing to attract outside financings in the coming years and VCs, loathe to admit losses, continuing to support them well beyond the length that a rational investor would.

To be clear, it is not only VCs who are induced into irrational behavior due to loss aversion. Entrepreneurs clearly suffer from this tendency as well, particularly when it comes to hiring and firing key executives. How often have you heard an entrepreneur say that they should have acted 6-12 months earlier in firing an employee that was not working out? The reason – loss aversion. Entrepreneurs are loathed to admit their own hiring mistakes and are fearful of the impact and magnitude of losing even a poorly performing team member. I know I certainly fell into this trap when I was an entrepreneur, and I see it is repeated time and time again.

Thus, I think the lessons of Sway are ones that all VCs and entrepreneurs would benefit tremendously from when evaluating how they make decisions. In an upcoming blog I might dive into the question of value attribution and the diagnosis bias, which are also a thought-provoking concepts that drive irrational behavior in VC partnerships. One entrepreneur identified another book for consideration on this topic called Predictably Irrational by Dan Ariely, which I have not yet read.

What are other examples can folks think of that fall into these irrational categories?

Like this:

One of our portfolio companies is raising money this year. It's a great company, run by a great CEO, and it will get funded in a competitive process. The CEO was briefing our partnership the other day and listed the firms he is talking to. In another start-up a number of years ago, he had been backed by an unnamed firm in Boston, led by an unnamed partner, and made them money. "Why aren't you going back to [insert name] at [insert firm]?" I asked innocently. "Life's too short," he replies pointedly, "to work with assholes."

At a time when there is likely to be some shakeout in the VC industry, a question that perplexes me is: Why do asshole VCs continue to survive?

Now don't get me wrong, I don't think the VC business is unique in its profile or behavior. According to the NVCA, there are 700 or so VC firms and 8,000 industry professionals (including associates, principals, etc). The vast majority of these folks are decent people. There are always a few bad apples in every barrel and an industry with type A, competitive people operating with very high stakes is likely to have its fair share. Talk to any entrepreneur who has gone through an extensive fundraising process and they will eagerly share some their favorite, colorful horror stories. So why do these VCs continue to succeed? Why isn't there a stronger, self-correcting feedback loop?

Here's the logic thread: the best entrepreneurs have choices, particularly those that have been successful before. They typically seek out the top VCs who are both smart/successful/value-add/relevant AND who are respectful/decent/good to work with (you can see my BCG roots coming through in the imaginary 2×2 matrix). Even if a VC is charming during the courting process, with minimal effort, reputations can be investigated and references carefully checked as to how they behave when things don't go according to plan. So why is it that Asshole VCs are able to persist? Shouldn't the best entrepreneurs avoid working with them and therefore shouldn't they be less successful over time?

One of my VC friends from Silicon Valley suggested one explanation: "Entrepreneurs get blinded by firm reputations and look past individual reputations. They don't do their due diligence on partners and check references carefully on the individual board member."

"If I were an entrepreneur given the choice between banging my head against a cinderblock wall for a year or taking money from [unnamed partner from unnamed firm]," observes one VC friend, "I'd opt for the cinderblock wall."

Ouch. With fewer financing choices for entrepreneurs likely in 2009, I hope they aren't faced with that sort of painful choice!

Like this:

I dodged the snowflakes and made the trek out to Sin City for this year's Consumer Electronics Show (CES). Although attendence was down, it is still an insanely large audience of 130,000 attendees and 2,700 companies. CEA head Gary Shapiro reported in his keynote that industy sales were up over 5% and that 2009 will be flat or slightly down. Not bad if true. His speech, by the way, was as much a political speech as it was an industry overview, further underscoring the importance of government activities in business affairs in the coming years. Two areas he hammered on were immigration policy ("expand H1B visas") and shooting down the ridiculous union-sponsored "card check" law (every large company business leader I have spoken to in the last 6 months is apoplectic over this bill and view it as a litmus test for Obama's centrist economic policies).

Tom Hanks appeared with Sony CEO Howard Stringer to pump Sony products and were very funny. But by far the funniest line of the day was heard from the very dour and serious head of Intel Capital. Seeking to assuage the nervous entrepreneurs amongst the portfolio companies that were in attendence at his networking lunch reception, he assured them, "We [Intel Capital] intend to continue forward and be very supportive of your down rounds this year". Ouch. He was probably just grumpy from the miserable results Intel announced to Wall Street the day before, with an unheard of 23% forecasted drop in revenue. That wasn't so funny.

Also not so funny were the general buzz and complaints bemoaning the lack of innovation. The next generation of flat screen displays and Blu Ray devices just isn't that exciting any more. Further, I was shocked at how empty the casinos were. I can see why the casino moguls are sweating it right now. The consumer electronics industry may be in for a stagnant year, but coming off a record year that would be a victory. But one look at all the frozen cranes up and down the strip is all you need to know that Sin City is in for a tough run in 2009 and 2010. But Intel Capital will be happy to invest in their down rounds.

Like this:

Among my holiday reading this year was Alan Greenspan's biography cum economic analysis, "The Age of Turbulence". In retrospect, the book's publishing date of mid-2007 preceded almost precisely the unravelling of the housing market in mid-2007 that eventually led to 2008 becoming the year of the largest market crash since the Great Depression. The book is thus a fascinating glimpse into Greenspan's brain on the eve of the crash.

In short, the erstwhile "Maestro" (as Bob Woodward tagged him in his 2000 book) clearly "missed it". One quote that really jumped out at me: "I was aware that the loosening of morgage credit terms for subprime borrowers increased financial risk, and that subsizdized home ownership initiatives distort market outcomes. But I believed then, as now, that the benefits of broadened home ownership are worth the risk." Ouch.

To get a glimpse of his current views, read his guest article in The Economist. At the end of the article, he points out that, to date, there has been $7 trillion in global sovereign credit pumped into the system ($1 trilion presumably from the US, which doesn't include the additional $1 trillion stimulus planned). This staggering amount of money is going to have to be inflationary at some point. With US Treasuries at 0%, it appears the market is more worried about deflation. But many economic commentators are very worried about inflation in years 3-10 (today's WSJ had a good range of interviews with some of them, so called "Doomsayers"). Greenspan himself points to long-term inflationary risk as "the rate of flow of new workers to competitive labor markets will eventually slow, and as a result, disinflationary pressure should start to lift".

So my big prediction for 2009 is that we will begin the year nervous about deflation, and end the year nervous about inflation returning. Interest rates will need to go up again in 2010 and 2011 to choke off the inflationary stimulus.

What impact all this will have on venture capital and entrepreneurship, I'm still sorting out. One thing is true, venture capitalists and entrepreneurs are operating at a very different end of the economic spectrum, creating new products and services that never existed and thereby creating value. Hence, I remain a long-term bull about entrepreneurial prospects. As Greenspan points in one section that really resonated with me: "[The 1990s] technology boom came along and changed everything. It made America's freewheeling, entrepreneurial, so-what-if-you-fail business culture the envy of the world." I guess I'll keep that photo of me and Alan on my desk after all…